There's a little understood but growing segment of the convertible securities market known as mandatory convertibles. In some ways, mandatory convertibles behave just like ordinary convertible bonds and convertible preferred shares, but in other ways, they are entirely different. In this article we examine the mandatory convertible to determine its unique nature, under what circumstances it should be purchased and when conditions warrant opting for an altogether different investment product. (Read Convertible Bonds and Introduction to Convertible Preferred Shares for a primer on these types of securities.)

A Quick Review
Generally, convertible securities are issued as preferred shares or bonds, which can then be converted into a specific number of the issuer's common shares at or before a specific date. Because they are convertible, convertible securities correlate with the movements of the common shares. Investors, therefore, enjoy the dual benefit of participating in the appreciation of the common stock as well as an enriched income stream. In addition, convertibles offer holders a muted downside risk; their higher yields buoy these instruments from falling in step with the common stock.

Mandatory convertibles, however, operate somewhat differently. They do have an enhanced yield over the dividend yield of the underlying common stock (historically in the range of 5-7% more annually), and they do convert into that same common stock, but that's where the similarities end. The differences are as follows:

  • Mandatory convertibles trade on the open market, unlike most convertible securities which trade on the over-the-counter (OTC) dealer market for institutional accounts. This makes them more accessible to the retail investor.
  • With mandatory convertibles, conversion to the common is not an option. The shares are converted automatically on or before a specific date - usually three to five years from the date of issue.
  • The number of shares received upon conversion is not known beforehand, but is based on the closing price of the common stock at the time of conversion. Call it a "variable conversion mechanism", which provides a greater number of shares the lower the common shares trade.
  • There is no par value return for cash as there is with a convertible bond or preferred, so in this regard they offer little downside protection.
  • The upside potential with mandatory convertibles is also limited.

What to Expect from Your Mandatory Convertible
In general, mandatory convertibles are designed to move hand-in-hand with the underlying common stock on the downside, while limiting upside participation. How this is accomplished is best understood by examining the constituent parts of the security.

Mandatories are hybrids of the following securities:

  • Purchase of the common stock
  • Sale of an at-the-money call option
  • Partial purchase of an out-of-the-money call option (i.e. an 80% call on the underlying)

The premium received on the sale of the call option is reinvested by the issuer in order to create a healthy income stream. (Read Options Basics if you're interested in learning more about options.)

The Key to Mandatory Price Behavior
In essence, the holder of mandatory convertible shares has written a covered call and holds an additional partial call option on the common stock. Therefore, if the stock falls, the mandatory falls with it (as would the value of any covered call). If the common stock rises significantly, the mandatory will also participate in the upside, albeit not in lock-step with the common. An example should help clarify this:

If the common stock rises ...
You buy 1,000 shares of a mandatory convertible. As the common shares rise you would not participate in the move until the out-of-the-money call is in the money. At that point, you would partake of 800 shares worth of upside. You would thus collect a relatively high payout while owning a stock that has little or no dividend - and still have access to longer term upside gain.

If the common stock falls ...
If the underlying shares fall, your mandatory will fall with it, as there is nothing to cushion the drop on the downside.

At the time of conversion ...
Remember that the moves described above will also be tempered by the ultimate conversion of the mandatory into common shares. Mandatory convertibles convert into fewer shares the higher the closing price of the common shares is at the time of conversion. So, if the common stock has gained 20% or more from the date the mandatory was issued, conversion might be around 0.8 shares per mandatory. If the stock lost 20% or more from the date of issuance, conversion might be 1.25 common shares per mandatory. In between a 20% gain and a 20% loss, shares would be converted on a sliding scale between 0.8 and 1.25 shares.

Those who are quick with math will see that the structure was created to convert the mandatory to the same number of common shares that were available at the time of issuance.

How Best to Employ the Mandatory Convertible
Given the structure and behavior of mandatory convertibles, one should consider purchasing mandatory convertibles only when one requires an immediate income stream and likes the company's near-term prospects, but the common shares offer little or no yield.

If, however, one is outright bullish on the company, a straight purchase of the common shares should be considered - or even the straight purchase of call options.

Finally, mandatory convertibles should only be considered for tax sheltered accounts as they do not qualify for favorable dividend tax treatment.

Mandatory convertibles behave very differently from other convertible investments and offer distinct advantages and drawbacks over straight purchases of the issuer's underlying common stock. A clear understanding of your investment goals will be the key to deciding whether mandatory convertibles are a "must have" for your portfolio.

Related Articles
  1. Bonds & Fixed Income

    Introduction To Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
  2. Bonds & Fixed Income

    Convertible Bonds: Pros And Cons For Companies And Investors

    Find out why businesses choose this type of financing and what effect this has on investors.
  3. Bonds & Fixed Income

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  4. Investing Basics

    Diversify with These Four Alternative Assets

    In times of market volatility, investors add alternative assets to their portfolios--highly illiquid, but profitable investments like art, land or precious metals.
  5. Investing

    How To Build a Currency Hedged Strategy?

    We are still unsure of how to implement a currency hedge strategy based on the dollar's movement. So let’s focus on what’s easier to measure: time horizon.
  6. Investing

    An Overview of Companies and Brands Owned by Yahoo

    Yahoo is much more than a web portal. Here are four companies owned by the multibillion-dollar conglomerate.
  7. Stock Analysis

    Top 4 Companies Owned by Comcast

    Read about the subsidiaries that make up Comcast Corporation's cable and media empire, and learn more about how they fit into the company's operations.
  8. Mutual Funds & ETFs

    How Interest Rates Affect Mutual Funds

    Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
  9. Economics

    The Effect of Fed Fund Rate Hikes on Gold

    Explore the historical relationship between interest rate increases and the price of gold, and consider what effect a fed funds rate hike might have on gold.
  10. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  1. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  2. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  3. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  4. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  5. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
  6. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!